Renewable fix

Renewable electricity in the UK is supported primarily by the Renewables Obligation (RO), an obligation on licenced electricity suppliers to purchase a proportion of their electricity from renewable sources. Most types of renewable electricity are eligible, and every unit from every eligible project is treated as having an equal value to the environment. Until now, that is....

Offshore wind has turned out to be much more expensive than envisaged. In the consultation document to the Government's recent Energy Review (published in January), cost estimates for offshore wind were listed from a variety of sources, ranging between 2-3p/kWh (the Government's own estimates) and 6-7.6p/kWh (although this estimate was projected to fall steadily to 3-4.6p/kWh by 2020). Renewable electricity has been worth over 9p/kWh for a while, and on top of that, offshore wind projects have been awarded over £100m in grants. Yet no offshore wind projects were being pushed forward. Something didn't stack up.

If there are two ways of producing a product, one cheaper than the other, the inventor of the cheaper technology will not expect to be paid less, but rather will expect to reap the profits of his invention (or why would he bother developing it?). The higher profits from this technology will encourage more people to invest in it, and produce more of the product more cheaply. If the cheaper technology cannot satisfy demand, some businesses will deploy the expensive technology to the extent that the price of the product covers the higher cost of production. These producers will not expect (or at least, not get) a higher price, but lower profits.

The RO was designed to work this way - by treating all renewables equally, it delivers the greatest profits to the cheapest technologies, encouraging those technologies to be developed to their greatest extent as a priority, whilst encouraging more expensive technologies to fill any remaining gap, to an increasing extent as that gap grows wider. It is not a perfect market, but it has its logic.

In the passage to the looking-glass world of Brownite economics, this logic is being reversed. The Government is consulting on a proposal to "band" the RO, so that more expensive technologies would get more support than cheaper technologies. No longer would products be worth what people thought they were worth, and identical products worth the same regardless of provenance. Now they would be worth what the Government thought their producers needed in order to produce them, based on what the producers told the Government (or their consultants) that they needed. Not surprisingly, some technologies are already starting to think that they need quite a lot more than they had previously estimated.

By paying more for the output of more expensive technologies and less for the output of cheaper technologies, the Government would get more of the expensive electricity and less of the cheap electricity. Though the micro-managers might claim otherwise, the adoption of banding would guarantee that our renewable electricity was more expensive on average than it otherwise would have been. We would never know whether the changes had delivered more power than would otherwise have been the case, but we can predict confidently that they would have increased not only the expense, but also the complexity and perception of political risk, both of which undermine the long-term prices that are needed to raise funds to develop those immature technologies that this proposal is intended to help. The proposal is a dog's breakfast, so it is a good thing that the Government are consulting before deciding what to do. Or are they?

The consultation ends on 5 January, after which the Government would need to weigh up the submissions before deciding how to proceed. If they decided to press on with banding, there would be another round of consultation on the levels that the bands should be set at, before proceeding to legislation, which they have announced could not be enacted before 2009 (by which time this Government may not even be in power). With the future so unclear, major investments on the strength of the proposed changes would be very risky. It is strange, then, that some of the major energy companies are pressing forward as though they already know the outcome of the process....

Eon and RWE are busy moving forward with their plans to expand their capacity to co-fire biomass with coal. Co-firing is limited under the current arrangements to no more than 10% of the total obligation. Most of the major generators, including Eon, are already producing as much co-fired electricity as they can use, and have spare capacity should it be needed. Under the current provisions, co-firing is gradually squeezed between now and 2016, when support under the RO ends completely. Under the banding proposals, the co-firing cap might be lifted. Without this constraint, investment in co-firing may well look like a good bet, but until then, such investment could be characterised as somewhere between risky and foolhardy. And yet Eon are pressing ahead against all financial logic. Unless, of course, they have reason to be more confident than the rest of us about the outcome of the review.

Such strange behaviour has raised suspicions amongst the less privileged members of the renewables fraternity. And today, those suspicions appear to have been confirmed. The Government announced its decision to approve the development of the largest wind-farm in Europe, offshore in the Thames Estuary. The project is apparently being "fast-tracked for delivery in 2008". That is one year before the legislation would be enacted, which is supposedly needed to make offshore wind economic. So the capital will be sunk before the developers know whether the project will be economic. That's a £500m gamble for the first stage alone, dependent on the outcome of two consultations and the subsequent passage of legislation. Would a company like Shell really press ahead with such a large investment without some sort of assurance that the changes will be brought in?

Apparently not, if we are to believe James Smith, Chair of Shell UK, the financiers of the project. He welcomed "the Government's commitment, made during the recent Energy Review, to adapt the Renewables Obligation". If he was referring to adaptation that would benefit his investment (and it is hard to see why else he would have mentioned it), this was news to the rest of us, who were under the impression that the Government had given no such commitment, and that the point of the current consultation was to inform their decision over whether to adapt the RO to treat immature technologies preferentially.

Perhaps Mr Smith knows more than the rest of us. Or perhaps this was just a slip of the tongue or an imprecise reference to the vague assurances in the Energy Review report. But if the latter, it was presumably a slip not just of the tongue, but of the mind, because this "misunderstanding" would seem to be vital to the investment decision. It is a tough call to make - has the outcome of the consultation on the Renewables Obligation been stitched up with the big energy companies in advance, or is the Chair of Shell UK ignorant about the political uncertainty on which a major investment depends? You decide.